With Growth Slowing, Enron's Fall Is Far From Over

It's now clear why Enron's (ENE Quote - Cramer on ENE - Stock Picks) stock has plunged more than 40% this year.

The energy-trading behemoth reported second-quarter results Thursday that betrayed several signs that its once red-hot business is slowing. Houston-based Enron also set mildly bullish 2002 earnings guidance Thursday of $2.15 a share, 2 cents above analysts' estimates. Recent developments, however, suggest this target will be hard to meet and that the stock should fall further.

Enron made 45 cents a share in the second quarter, 3 cents more than Wall Street expected. It also confirmed its 2001 earnings guidance of $1.80. The stock rose 0.9% to $49.55 Thursday.

Gotta Get Broadband

At first glance, the most shocking part of second-quarter earnings was the $102 million operating loss from Enron's broadband operations; for the previous four quarters, the average operating loss there was just $24 million.

Launched just over a year ago to great applause from Enron's ardent sell-side analysts, this business is now in intensive care. Enron CEO Jeff Skilling, whose recent heavy sales of company stock make him one of the biggest Enron bears in the market, didn't attempt to sugarcoat the result. "There's a meltdown out there," he said on a Thursday conference call in reference to the broadband business.

While the broadband loss was blatant and ugly, other less obvious trends gave cause for concern.

Wholesale Slowdown

For example, key revenue numbers slowed. The wholesale services division, the trading and investment unit that accounts for 97% of Enron revenue, reported a slight sequential quarterly decline in its top line, compared with sequential gains of between 20% and 75% in the previous four quarters.

Outage Enron sliding in 2001

Wholesale service second-quarter revenue of $48.48 billion was essentially flat with the previous quarter's $48.51 billion. It was up 204% up from the year-ago level, reflecting the explosion in energy volumes and volatility over the past 18 months. But this rise was well below the near-300% year-on-year increases posted in the previous two quarters.

How about profits? Wholesale reported second-quarter operating earnings of $802 million, up 6% from the previous quarter and 93% above the year-ago figure. Operating earnings in the commodity sales and services line, the largest part of wholesale, fell 3% sequentially to $762 million, though they rose 81% from a year ago.

Wholesale benefited from a sizable increase in earnings from the so-called assets and investments line, the other business in the segment.

Earnings from assets and investments are considered to be of lower quality than those from the commodity sales line because a good chunk of the returns depends on profitability assumptions made by Enron itself. Assets and investments brought in $134 million in operating earnings, up well over 100% from the immediately previous and year-ago periods.

Changing Times

On the call, Enron investor relations executive Mark Koenig said about a third of the assets and investment earnings came from recurring income that Enron receives from operations in which it invests. However, a good part of it came from valuation adjustments to its portfolio of merchant investments. Koenig said Enron had "better valuations" in the portfolio compared with the year-ago quarter.

Now, it's just about possible that portfolio valuations have risen over a 12-month period. But it's really hard to see how valuations can have increased so much from the first to the second quarter, as implied by the big jump in asset and investments income. Remember that in the first quarter, earnings from assets and investments tanked. Enron's quarterly financial filing with the Securities and Exchange Commission said that the decline was "a result of a decrease in the value of Wholesale Service's merchant investments." What radically changed in the second quarter to reverse first-quarter softness?

Enron provides enough disclosure of expenses to do close-up margin analysis of some of its business lines. Maddeningly, however, it doesn't break out costs for the two businesses included in the massively important wholesale segment: commodity sales and services, plus assets and investments.

The overall operating margin on wholesale was 1.65% in the second quarter, up from 1.56% in the previous quarter. Fine, but was the margin improvement from the easy-to-tinker assets and investments line, or commodity sales? Enron doesn't make it possible to tell.

Margin Squeeze?

Skilling also noted that Federal Energy Regulatory Commission plans to set up four regional electricity transmission organizations would be a big plus for Enron. These regional transmission organizations, or RTOs, "will benefit the type of business that Enron does," Skilling said.

However, while the RTOs may boost Enron volumes, they could also bring greater efficiency and therefore reduced trading margins. Investors may argue how long it will take for these efficiencies to hurt Enron's profits, but one thing is clear: Wholesale's operating margins are already under pressure, falling from 2.6% a year ago to 1.65% now.

The subject of Enron's related-party transactions came up on the call. These have sparked much chatter because it's not clear how much Enron's earnings have been aided by deals done by these entities. When an analyst asked Thursday about impact in the second quarter from an entity called LJM Capital Management, whose general partner is Enron's chief finance officer, Andrew Fastow, Skilling said LJM had done "a couple of real minor things." Again, little else was disclosed.

Enron now trades at 23 times its expected 2002 earnings. Because it's little more than an energy-focused investment bank, it should have a price-to-earnings ratio of no more than 17. Using that multiple on expected 2002 profits would take the stock down to $37. But since this column considers $2.15 to be ambitious, and since disclosure is poor, Enron should trade at 15 times $2, which is $30. Oh yes, that's 40% further that Enron has to fall.